The Ultimate Bitcoin Question: Can the Feds Spend $3.3M in Seized Digital Currency?

When the FBI seizes millions of dollars in cash from some warehouse at the heart of an urban drug cartel, the money winds up in a government building somewhere and eventually finds its way into a government bank account, where it helps finance all sorts of government stuff, like the next FBI drug bust.

But what happens when the feds bust an online drug marketplace and confiscate millions of dollars in bitcoins, the wildly popular digital currency that doesn’t exactly align with the government’s way of doing things — and so often serves as a convenient means of money laundering? What will become of the $3.3 million in bitcoins the FBI seized after shutting down the Silk Road early last week — not to mention the $80 million or so in bitcoins they’ve yet to seize from the personal account of the man who allegedly ran the online drug bazaar?

What does it even mean to seize money that exists only on the internet?

These are questions even the cleverest internet thinkers will struggle to answer, let alone the federal government. A Department of Justice spokeswoman couldn’t tell us what the government is likely to do with the seized bitcoins, and a spokeswoman in the FBI’s New York field office said she’d have to contact bureau headquarters in Washington, D.C. before discussing things in any detail. The most she could say is the bureau may look to liquidate the funds, as it would with a confiscated Lamborghini.

‘At this early point in the history of bitcoin, I would be very surprised if the government has existing written policy on what to do if you seize digital currency.’

— J Cabou

Uncle Sam has seized bitcoins in the past, but nothing so large as the stash from the Silk Road bust. Like the rest of the world, the government is struggling to come to terms with this brave new currency. With the feds belatedly pushing for regulation of the bitcoin system, many people are having trouble converting their digital currency into cash. If the feds then decide to cash out their own bitcoins, you’ve got a conundrum.

“At this early point in the history of bitcoin, I would be very surprised if the government has existing written policy on what to do if you seize digital currency,” says Jean-Jacques “J” Cabou, a partner with the international law firm Perkins Coie who is an expert on federal seizures and is very familiar with bitcoin. And even if the feds have a pretty good idea what they’d do with the bitcoins today, they can’t move until the Silk Road case is decided. That could take years, and the bitcoin landscape could be completely different by then. It’s changing by the day.

At the moment, we don’t even know how the feds accomplished the Silk Road seizure in the first place. That FBI spokeswoman says investigators “downloaded” 26,000 bitcoins from a Silk Road online wallet, but that’s all she said. That could mean many things.

Bitcoin wallets are controlled with two cryptographic keys represented by long jumbles of numbers and letters. There’s a public address number anyone can use to make payments with the system, and a second, private cryptographic key number you need in order to send bitcoins to someone else. These private keys can be stored on a computer, a thumb drive, even a piece of paper. Presumably, the FBI obtained the private key to the bitcoin wallets Silk Road used in its escrow payment system, then transferred the contents. The FBI says that, due to encryption, they’ve been unable to get access to the personal wallet of alleged Silk Road mastermind Robert Ulbricht. That wallet probably contains much more money. The FBI says he earned more than 600,000 bitcoins in commissions over the life of the site.

“When they say they’ve seized bitcoins, what do they even mean?” asks Cabou. “I know a fair bit about seizure and I know a fair bit about bitcoin, and I don’t exactly know what they’ve done in this case.”

If we don’t know how they got the 26,000 bitcoins, we do know where it all wound up. According to those who tracked where the money went online, it is now stored in a single bitcoin address. We know this because the bitcoin system is public — at least in part. It’s a voluntary collaboration of thousands of independent machines across the internet, and every transaction is broadcast to the whole network. That means you can observe the address where someone stores their bitcoins and, if you like, instantly transfer money to that address. Many people have started transferring tiny amounts of money to the presumed FBI address, just so they can post public messages that make fun of the federal government.

That transparency is an obstacle to the most obvious way that law enforcement could use the seized bitcoins: undercover buys. Federal investigators made 100 such purchases from Silk Road drug dealers before moving in on the site. In theory, an additional $3.3 million in bitcoins would be great to have on hand when the inevitable Silk Road successor sites spring up. But even if the FBI breaks down the seized bitcoins and tumbles it through other wallets, it would still be traceable back to the FBI wallet where it is now parked. It is, for undercover purposes, tainted forever.

Their best option, then, is to find some way of moving the money into a government bank account, where it can be spent. With conventional cash seizures, we know how that works. A bank transfers money to the U.S. Marshals Service, and then the funds are held in a federal account until they’re disposed of in a some way by order of the court. But in this case, there’s no bank for the court to order to hand over funds. The only way to get at the funds is through bitcoin’s online system — which isn’t controlled by any one person or organization.

The feds could just trade the bitcoins for dollars on a popular online exchange such as Mt. Gox. But they aren’t likely to do that either. Because of government scrutiny, Mt. Gox is having trouble getting U.S. dollars out of its exchange, and we can’t imagine the government would submit itself to a process it doesn’t completely support. After the government cracked down on Mt. Gox earlier this year for not properly registering itself as a money transmitting business, Mt. Gox has been unable to find a U.S. bank willing to work with it.

As Cabou points out, Mt. Gox or other exchanges presumably would have to be approved as a government contractor before the feds would use it — and that doesn’t seem likely, at least not in the short term. “It would surprise me if they used one of the exchanges,” he says.

And if the FBI did use a third-party to liquidate its bitcoins, it would have to ensure that third party didn’t run afoul of state and federal money transmission guidelines, says Carol Van Cleef, a partner with the Patton Boggs law firm who advises companies on these type of federal requirements. “It creates some interesting issues,” she says. “Right now, we have a dearth of exchangers who are in a position to actually handle these transactions.”

Given the murky regulatory landscape surrounding bitcoins, the government could opt to destroy the stash — or let it sit on the internet forever, doing nothing. That’s what WIRED is doing with its (much smaller) collection of bitcoins because ours were a kind of gift that we’d rather not spend, for ethical reasons. But the longer the FBI holds the bitcoins, the harder it will be to let go. By the time the Silk Road prosecutions are concluded, those 26,000 bitcoins could be worth several times more than $3.3 million.

“With this much valuable property at stake,” Cabou says, “they certainly will want to get the money.”

‘How they decide that question will hinge on whether they consider bitcoins to be more like an asset.’

— Patrick Murck

The likely outcome here is that the feds will treat that $3.3 million in bitcoins as something other than money. They’ll treat it like an asset. They’ll auction it off — either in-person or online — much as they would a house or a car or a piece of land or a baseball card.

We may see people gathering in a room somewhere, holding up large wooden paddles as they bid dollars for currency that exists only on the internet. “What does the FBI do when they seize a car? They sell it. They sell it at a Marshals’ sale.” Cabou says. “They could simply decide to have a Marshals’ sale of the bitcoins. The Marshals Service sells all kinds of assets.”

If feds do this, it would be a clear indication of how they view bitcoins. In an affidavit filed in the Silk Road prosecution, the FBI acknowledges that bitcoins can be used for legitimate purposes, not just illegal activity, but if they decide to auction the seized bitcoins, it would show that it doesn’t really view it as legitimate money, providing at least one answer to the biggest existential question: What is a bitcoin?

“How they decide that question will hinge on whether they consider bitcoins to be more like an asset,” says Patrick Murck, general counsel with the Bitcoin foundation, the organization that oversees the digital currency.

But as we wait for an answer, those bitcoins will just sit there. And — barring a crash — the longer they sit there, the more they’ll be worth. And, as the clock continues to tick, so many more organizations will be accepting bitcoins as a form of payment, for everything from laptops to lunch. In the end, the feds may have very little trouble with all those bitcoins. They may just spend them.